There are a lot of reasons that trading options is gaining popularity, and one of the most crucial factors is the flexibility and leverage offered via the endless amounts of options strategies.

One of the more "complex" strategies is the ratio calendar spread, a way to initiate a position with a directional bias while utilizing the spread of the implied volatilities across two months to enable a smaller cash outlay, hence the calendar portion of the spread.

A traditional calendar spread generally involves selling a front month option, call or put, and buying the same strike option in the next expiration month. You can also use different strike prices, and in that case, it becomes a diagonal spread, different months and strikes. Calendar spreads benefit from theta decay, also known as time decay, in which the front month options decline in value at a much faster rate than the next month as options expiration nears.

Traditionally, in a trending market, I will use calendar spreads with ten or fewer days remaining until options expiration, leaving less wiggle room for shares to move outside your profit zone.

This calendar spread strategy can be modified by using a ratio spread, selling two or more front month options for every one bought in the following month, effectively initiating a more negative theta position and allowing for a cheaper debit on the spread.

Although calendar spreads are often profitable in the days leading up to, and the day of, options expiration, I tend to initiate these trades with a directional bias with the full intention of having the front month options expire worthless and holding the long option that I will own at a significant discount that gains value as shares continue in their trend. Keep in mind that you would use a call spread for a bullish bias and a put spread for a bearish bias.

Volatility, as with any options strategy, is also an important factor when choosing calendar spread candidates, looking for a wide spread between the implied front month volatility (time 1) and the volatility in the month of the long option (time 2). Often, companies reporting earnings during the week of expiration are suitable choices, with the front month volatility climbing ahead of the catalyst.

A Case Study
The easiest way to understand the strategy is to create an options strategy for this expiration week, and I will look at FedEx (FDX), which reports earnings on March 18.

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FedEx shares have consolidated the last ten trading sessions ahead of this quarter's earnings, with consolidating stocks a great target for calendar spreads. Shares are trading at $86.18 and have a gap to fill to $89.64, with $92.47 the most recent highs from January. The transports (IYT) as a sector have broken out to new highs, but FedEx has lagged without a catalyst, and I have a bullish bias heading into earnings as consumer spending rebounds and shipping traffic in both the rail and air freight segments have shown significant improvements in the last few months.

A simple ratio calendar call spread strategy here would involve selling two of the March $90 calls to help finance the purchase of one April $90 call, or 20 x 10, etc. The March $90 calls can be sold at around $0.60 a piece, while the April $90 calls can be bought at $1.45, the spread requiring a net $0.25 debit.

FedEx is also an alluring target for this type of spread because it not only reports earnings the day before options expiration when there is a major decline in vega, volatility, across all stocks, but it also has a March implied volatility reading of 39%, while April sits at 28%, an 11% spread, or in relative terms, approximately 40% above April's level. The net theta on this position is -0.18, which will accelerate into expiration.

The spread is profitable with shares between $81.25 and $91.75 following earnings, well within the range that the current at-the-money straddle is pricing in. The profit and loss graph is below.

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The best-case scenario is that shares close at $90 even on options expiration, the March calls being worthless and the April calls trading around $2.60, a 940% gain on the initial debit. If shares climb higher following earnings and remain under $90, the same scenario applies, but if shares rise above $90, you will be able to exit the spread for a profit as the April calls will retain more time value and vega than the March calls, following the implied volatility collapse post-earnings.

Ratio calendar spreads, when used properly, offer high reward, low risk, and high-probability trades that use the flexibility of options trading to its fullest extent.